This page is a collection of reflections, contemplations, thoughts; about life, about death, about people, about stock markets, about science, about scientists, about economy, about economists, about art, about artists, about books and authors...

One of the most famous proverbs
in the financial world is, “Don’t put all your eggs in one basket”. The idea
behind diversification is risk reduction by investing in a variety of assets.

Conventional theory also says
that risk and return are proportional to each other. Diversification results in
the reduction of risk, but returns also reduce.

John Maynard Keynes, the father
of modern macroeconomics, held quite different views. Keynes believed that
investing in a few stocks gives much better returns than diversification and
his faith in portfolio concentration rewarded him far with superior returns
than a widely diversified market portfolio. In his view, an investor who knows
something about the market can get better returns by holding few stocks rather
than a variety of assets.

Keynes also argued that a
concentrated portfolio would be less risky than a diversified portfolio because
the investor could undertake due diligence of stocks if his portfolio is
limited and would typically invest within his circle of competence.

“As time goes on, I get more and
more convinced that the right method in investment is to put fairly large sums
into enterprises which one thinks one knows something about and in the
management of which one thoroughly believes. It is a mistake to think that one
limits one’s risk by spreading too much between enterprises about which one
knows little and has no reason for special confidence,” said Keynes.

In a way, Keynes was emulating
the idea of specialisation propagated by Adam Smith — the father of economics —
who believed that breaking down a large job into many small jobs makes each
employee an expert in one isolated area of production and thus improves
productivity, which leads to higher economic growth.

Expansion of a portfolio beyond a
certain number of stocks dampens performance because one loses the ability to
effectively monitor the holdings. Keynes once said, “To carry one’s eggs in a
great number of baskets, without having time or opportunity to discover how
many have holes in the bottom, is the surest way of increasing risk and loss.”

In a research paper by Professors
Zoran Ivkovi´c, Clemens Sialm and Scott Weisbenner, Portfolio Concentration
and the Performance of Individual Investors published in the Journal of
Financial and Quantitative Analysis in 2008, the authors show that investments
made by households with concentrated portfolios outperformed those with
diversified portfolios. The results indicate that households with concentrated
portfolios evolve the ability to identify stocks that give higher returns.

A few other advantages of a
concentrated portfolio are lower transaction costs and potentially lower
monitoring costs. In comparison to a diversified portfolio holder, the
concentrated portfolio holder has the fear of loss and that fear influences him
to rigorously scrutinise companies before picking a stock.

For people who do not have risk
appetite, or do not understand the business of the company in which they are
investing, it is best to diversify.

Most fund managers invest in
diversified portfolios as their customers may not have the ability to take a
large loss. But those who have the risk-taking ability and appetite, besides
the expertise to identify good stocks, might want to try their hands at
concentration!

Are Massive
Open Online Courses (MOOCs) here to stay? Well, no one really knows. They are
the new buzz on the education circuit and top universities are rallying to get
a share of the pie. Though there is definite merit in learning from a professor
and fellow students in a physical classroom, the business of education would
flourish by roping in more and more students, and in this respect the
traditional channel has certain limitations which the online channel does not. With
starkly different learning impacts and revenue models, one must be candid in
saying that this alternative method cannot be considered a replacement for the
traditional method. At best, it can play a complementary role. However, factors
that impact its sustainability and longevity are yet to be understood or
managed.Started
by reputed institutions with the aim to democratize education, Coursera, edX
and Udacity are the pioneers in the area of online education. While MOOCs have
come into existence only since 2011, each of the three institutions offer
staggering 500 courses on an average.
The courses are 3 to 17 weeks in length and have 30000 to 40000 students in
each course on an average. The highest number of registrations for a popular
course has been as high as 240,000. Average completion rate for the courses
remain low at 10%.

Most of
these are run by the star, mostly tenured, professors of elite institutions.
Currently these courses are mostly free as they are subsidized by universities
and venture capitalists (VCs). For example, edX and Coursera received $60 million and $16 million respectively from
the VCs in the last two years. Eventually, when a successful revenue
model is developed, these professors would be well positioned to mint money.A fact
that cannot be refuted is that the learning that happens in a classroom
environment within an institution cannot be equaled in an online scenario. Peer
group interactions and time spent with professors outside the classroom
contribute towards a well-rounded personality. Campus life also promises a
great opportunity to start business ventures in collaboration with peers. This
kind of collaboration and networking is almost impossible to develop while
being co-participants or co-learners in an online course. Whatever be the
number of chat rooms created during an online course, who does business with a
social network friend, especially if they have never met? Moreover, university is
the platform where students assimilate different cultures, languages and
cuisines, all of which make them truly global citizens. Globally, between 2010
and 2012, 6.7 million online course enrollments concluded in mere 670,000 completions.
Though we do not know the usefulness of the courses for those who completed
them, we do know that experiments have found that only 50 percent of
credit-seeking students passed an online course as compared to 75 percent of
students who undertook the regular course in a classroom. So why waste VC money
on comparatively ineffectual online courses? This money could well be used in
creating new institutes of higher learning or in creating branches of existing
reputed institutes. That would ensure accessibility to good education.Turning to greener pastures, MOOCs
plan to tap into the lucrative executive education market. Though online
courses reduce cost to company, employees scorn on them as these reduce their
time off from the job, travel and networking opportunities- aspects on which the
physical classroom scores. Even short training programs arranged by the
employers are attractive as they provide an opportunity for face to face
interaction.

One of
the biggest pluses of MOOCs, however, is their reach and in that they can
complement regular brick and mortar courses. A university can expand the reach
of its unique classroom courses, taught by a handful of experts worldwide, by opting
for the online channel. In the field of executive education, especially for new
hires, MOOCs can act as a post training module. Thus, if used innovatively, MOOCs
can co-exist with the regular classroom training, especially because they are
more cost-effective than their traditional counterparts.

If
learning impact is one concern with regard to MOOCs then untenable revenue
models is another. There is an eerie resemblance between MOOCs and the dotcom
companies of the 1990s. The dotcom companies based their valuations on the
number of eyeballs and clicks, which fetched them huge investments from venture
capitalists. Similarly, MOOCs seem to be after number of enrollments. Dotcoms
did not have a solid revenue model in place, which is the case with the MOOCs
of today. They are toying with a multitude of options for getting their revenue
much earlier in their lifecycle than dotcoms, however they need to get their
revenue model right. Several profitability ideas are being brainstormed in the
online education circles. These range from charging a nominal fee for giving a course
completion certificate to charging users for complements offered by the online
education providers to charging recruiters who hire students of an online
course. However, all these ideas need to be tested and until there are signs of
profitability, the fate of MOOCs remains uncertain.

Lucky
scratched his head. Looked around. Buried his head again in the
newspaper.

Looked
up again. Scratched his beard. Got up and hesitantly walked up to the lady
sitting on the far end right corner of the student lounge at the University.

She
looked up at the smartest guy in her executive education class. Lucky was a
successful software developer, who had made money through stock options that
his company gave him for performance. Gesturing him to take the chair opposite
her, she asked, "where are you lost?".

"Look
at this Professor Nicky", said Lucky, holding out the newspaper to her and
pointing at the article that he was reading.

Lucky:
I have some money as fixed deposit with my bank. It is giving me a return of
9.25 percent per annum. I know it is a very safe way to get returns. But I also
know that I am not maximizing my returns.

I may get more returns by taking some measured risk. I am a bachelor. I don't
need to send money home. I can afford to take some risk.

But
I don't know how to go about doing it. I am comfortable with programming, but
finance scares me. If you can help me understand this article and what is
modern portfolio theory, I might get over my fear and get started.

Nicky:
But you can go to an investment advisor!

Lucky:
Yes. But I don't want to. I have had a bad experience earlier when one of them
sold me a Unit Linked Investment Plan and I lost half of my invested money. I
later came to know that they get a hefty commission for selling some of the
products. So now I want to manage my investments on my own.

Nicky:
Well, once bitten twice shy. But not all investment advisors are bad. And now,
even the regulators are tightening the norms and making it safer for the
investors. Having said that, it is good that you want to manage your own
portfolio.

Let
me start from the beginning. Harry Markowitz, a Nobel laureate in economics,
introduced modern portfolio theory, a theory of finance that shows how risk
averse investors can construct portfolio to maximize expected return for a
given level of risk or to minimize risk for a given level of expected return.

He developed a simple framework, known as Mean-variance analysis, to analyze
the tradeoff between risk and return. To diversify the money in risky and risk
free assets, the first step is to find the optimal portfolio of risky assets
and the second step is to find the best combination of risk free asset and
optimal risky portfolio.

Lucky:
Now you are losing me. Risk free? Optimal risky portfolio?

Nupur:
Risk free assets are typically government issued short term bills or bonds.
Even though technically a fixed deposit is not risk free, you may consider it to
be close to risk free and continue to invest part of your money in fixed
deposits.

An
optimal risky portfolio is the market portfolio that provides maximum reward to
risk ratio; in other terms, the best combination of risky assets to be mixed
with safe assets to form the complete optimal portfolio. It can be
constructed by using a simple tool, Solver, in excel.

Lucky:
This article here says that there can be many minimum variance portfolios. If
that is the case, then which one should I choose?

Nicky:
On right track! To build an optimal risky portfolio, you need to maximize the
ratio of portfolio excess return to portfolio risk (standard deviation). This
ratio is known as the Sharpe Ratio. Once you find the portfolio which maximizes
the sharpe ratio, you can take that portfolio and invest part of your money in
it and the balance in a risk free asset.

Lucky:
How will I know how much to invest in each?

Nicky:
Ah that really depends upon how much risk you want to take. If you don't want
to take any risk, then your investment in risky portfolio will be zero percent.
But if you want to take some degree of risk, then you will invest say 30 or 40
percent of your money in the risky portfolio and balance in risk free assets.
It really depends upon your risk appetite.

Lucky:
Wow! And all this was told by Markowitz?

Nicky:
Yes. And he said many more things. But I guess this is enough for today. If you
want to know more about his and his theory, google his name and you will find
his originally published paper in the Journal of Finance in 1952.

I wish somebody had told me these
things when I was a student of Finance and while I was pursuing a PhD in
finance. I would have had a much better perspective of how and why things work
(or don't) the way they do! That's the first thought that came to my mind when
I read the first book of the trilogy tracing the evolution of money.

The second thought was that this
indigenous writer has written a book which is truly global in every sense. I
would take the liberty of placing him in the same league as a Niall Ferguson or
a Peter Bernstein, even though this is Vivek Kaul's first book.

We have heard of many college
dropouts who have gone on to become billionaires. Here is an example of a PhD
dropout, who it seems, is on the path to becoming a best-seller and an
authority on Money, its evolution, regulation and consequences.

'Easy Money' published by Sage
Publications takes us through the era when anything and everything was treated
as money in some or the other part of the world. From salt, to dried cod, cowry
shells to cattles and even slaves! Going as long back as the 12th century BC,
the book chalks the path for evolution of Gold as money by meticulously laying
forth the problems with alternatives and with having too many different money
types.

There are many interesting facts
throughout the book. It is fascinating to know that it was the Chinese who
first started using coins and that they "believed that money is meant to
roll around the world, and so it should be round". That the Chinese thought
of this in the 12th century BC is fascinating.

The depreciation of the currency,
or debasement, as it was known in the early centuries of the Christian era, and
practised by reducing the metal content in the coins, eerily echoes the concept
of printing more and more paper money to meet expenses, whereby 'money'
systematically loses value.

From barter to commodities as
money to paper money and then the evolution of the banking system, the journey
has lessons, as highlighted by the author in the conclusion, that all
regulators would do well to imbibe. Wildcat banking, free banking, bailing out
institutions existed centuries ago as well. But we have not learnt from history
and hence history repeats itself.

Kaul weaves together stories from
Egypt, China, India, Rome, USA and UK effortlessly, as also he does with Marco
Polo, Leonardo Fibonacci, Kublai Khan and the kings of the United Kingdom. He
explains the evolution of concepts like 'settlement' and 'bill of exchange'
through simple examples which make the book highly readable by even those who
do not have a basic degree in Finance, Accounting or Economics. The research is
thorough, language simple, stories fascinating. Everyone should read it.

Lucky was fascinated by the world of
stock markets. He had started investing the money made from his stock options
in equities a few months back.

The stocks were mostly selected based
on recommendations made by analysts on business news channels and the
newspapers.

Having lost 60 per cent of his
principal invested in a particular stock, he decided to take matters in his own
hands and learn about stock selection rather than depend on other. With
determination in his eyes, he knocked at Professor Nicky's door.

Nicky:
Good to see you Lucky. What brings you here?

Lucky:
Professor, I invested in a stock based on a recommendation, where the analyst
had used Price-To-Earnings (P/E) multiple. Before you accuse me of
blindly following the analysts, let me clarify that I did Google the term, did
my own analysis and then took a call to buy.

Nicky: The dark
side of valuation!

Lucky: What do
you mean?

Nicky:
Let me elaborate. The same multiple can be defined in different ways by
different people. Multiples can be misleading if you don’t know what
fundamentals drive each multiple and how the multiples are estimated.

Price to earning is not the only
multiple, though it is the most common. There are numerous multiples that
exist.

A multiple is simply a ratio of two
financial variables where enterprise value (measure of market value of all the
securities, viz. common stock, preference stock etc., of a company) and equity
market capitalisation (measure of market value of just common stock) are
used in numerator and various proxies for cash flow are used in denominator
such as Earnings Before Interest and Tax (EBIT), Earnings Before Interest Tax
Depreciation and Amortisation (EBITDA), Book Value, Sales, Employees, etc.

Lucky: But how
do we know which is the right multiple to use for a company? This analyst
always uses P/E Multiple.

Nicky: Keep in
mind that you can’t use these numerators interchangeably to define a multiple.
When the denominator is an enterprise level quantity such as EBIT, EBITDA,
Sales or employees, you should use the enterprise value in the numerator; and
when the denominator represents the shareholder level measure such as earnings
or book value of equity, you should use equity market value in the numerator.

Lucky: That
makes sense. But you did not answer my question. I am wondering whether any specific
multiple is used for a particular industry.

Nicky: Yes.
Some multiples make more sense for a certain industry than the other multiples.
For example, Price/Customer multiple can be used to value Cellular phone and
Internet companies while Price/unit multiple is suitable for soft drinks and
consumer product companies.

Price
to Earnings-growth ratio is generally used for growth Industries such as
technology, health and luxury goods.

Lucky: What
about Banks?

Nicky:
Price/Book value is the more appropriate multiple for valuing a Bank. However,
you must realise that when valuing a company using multiples, average multiple
of the rest of the companies in the industry or few select companies in the
industry is used.

If
the company which you are valuing, is very different from the other companies
in terms of size, geographical area of operation, growth prospects or
technology used, you may not get a meaningful value for the company using
multiples.

Lucky: What
about other valuation techniques?

Nicky: There
are many. Discounted cash flow method, dividend discount model, moat based
valuation, etc. The key is to figure out which model is best suited to the
company, which you want to value.

Lucky: Now, I
realise why you earlier said, “The Dark side of valuation”.

Nicky: Yes.
While valuation can be tricky, it is still better to invest with 'informed
ignorance' than total ignorance.

The Chutupalu valley, about 30
kilometers from Ranchi, capital of the state of Jharkhand, in India, reminds
you of the beauty of some of the hill stations in northern India. But apart
from the greenery, as far as the eye can see, an occasional rainbow and foggy
mornings, what characterizes the valley is the sight of hundreds of men pulling
their cycles uphill, with 10 to 20 sacks of coal loaded on each.

They buy the coal from various
mines or from illegal miners near the Ramgarh district, load the sacks of coal
on their cycles early in the morning and start the journey to Ranchi. The
journey, one way, is about 80 kilometers. The elevation is about 1000 ft. The
weights on each cycle could be anywhere between 150 to 200 kilograms.

They take one and a half days to
reach Ranchi, where they sell the coal to local restaurants and households and
make Rs 400-500. They return to Ramgarh on the evening of the third day, only
to start the three-day cycle starts once again the following day. Their
earnings are often less than the average minimum daily wage of Rs 155 per day
(2012-13) under the Mahatma Gandhi National Rural Employment Guarantee Act
(MNREGA), and in inhuman conditions.

Their bare, cracked feet,
blackened and wet (from sweat) vests, and blackened trousers pulled up above
the knees make you wonder about the motivation for undertaking such hardship.
Ask them and the answer is simple: “Pet ke liye”
for food.

That the benefits of MNREGA, the
flagship programme of the United Progressive Alliance government, does not
reach them is obvious. So may be the case with the Food Security Act as well
whenever it is rolled out in Jharkhand. That the state and the central
government don’t know about these ‘coal pullers’ is also not believable as they
are as much a part of the valley as the rocks and the trees.

There are no official statistics
on the number of people engaged in pulling coal in the region. While people have
been engaged in coal picking and selling them locally since the last 40 to 50
years, the numbers were small till about 15 years back. But they have been
steadily increasing. A rough estimate is that around 7,000 to 8,000 men are
involved in this activity in the Ramgarh district. Around 1,000-2000 of them
would be operating between Ramgarh-Ranchi, through the Chutupalu valley. There
has been no effort to either organise them or help them in any way.

They are often accused of
stealing coal. “This is not right,” one of them says. “We buy from some people.
Where they get it from, we do not know”.

Theft is a factor often
attributed to the shortage of coal in the country. Coal mines in India, mostly
in the central and eastern part of the country, are located in isolated hilly
terrain and tribal areas. These underdeveloped areas, low on socio-economic
development, are perfect setting for anti-social activities such as coal theft.

According to a report by
Infraline Energy Research, New Delhi, people in these areas, steal coal from
all possible avenues. They come in groups, outnumber the security personnel and
take coal from stockyards. They create huge bumps on the road to slow down open
trucks loaded with coals and loot away tons of coal. In another adventurous fashion,
they arrest railway sidings, stop trains and take away hundreds of sacks of
coal in a jiffy. These groups include men, women and children – on foot, on
bicycles and on bullock carts. These groups of looters, local unemployed
people, are controlled and supported by mafia in these areas. They steal 50-100
bags at one go and later sell it to the mafia for small sum of money who later
make big profits in black market. This is the way of life for thousands of
families in the state.

However, these coal pullers
vehemently deny such charges. They maintain that they have nothing to do with
the coal thieves or the mafia. A coal puller says, “We don’t want to do this.
We know that in three to four years we will permanently spoil our knees and
develop other severe ailments. If we stole, life would have been easier. But we
don’t steal.”

In a state which is known as the
coal capital of India, such a plight is an irony. On the one hand, billions are
being made by industrialists and politicians through just the allocation of the
coal blocks, and on the other are the hardships suffered by these coal cycle
pullers for a pittance. It is a shame.

Friday, November 1, 2013

The second part of the gold analysis was published in the beyondbrics blog of the Financial Times on October 31, 2013. Once again my comments were used in the article. Do read it by clicking on the link below:

As a hedge fund manager, Mohnish Pabrai does not have to be fully
transparent with his results- except to the investors who receive his reports.
But he makes no secret about his targets and successful results in terms of
compound returns, nor about the fact that they are grounded in value investing
principles, particularly those espoused by Warren Buffett.

Anyone can gain insight into Pabrai's way of thinking in books he
has written: "The Dhandho Investor: The Low - Risk Value Method to High
Returns" and "Mosaic: Perspectives on Investing".

Pabrai talks up a principle of his own, which he describes as
cloning. Successful formulas are visible for all to see, but, as Pabrai
observed in a recent interview, there is something in human nature that
devalues cloned ideas and strategies. “Be a cloner… but clone the best”, advises
the managing partner of Pabrai Investment Funds.

The Irvine, Calif. firm is billed as a family of hedge funds
inspired by the Buffett Partnerships, with more than $500 million of assets.

A Mumbai native and former IT consultant- founder of TransTech in
1990, which was sold 10 years later to Kurt Salmon Associates- Pabrai won the
1999 Illinois High Tech Entrepreneur Award given by KPMG, the State of Illinois
and the City of Chicago. In 2005 he and his wife, Harina Kapoor, started the
Dakshana Foundation, with the goal of recycling most of their wealth. The
foundation is focused on alleviating poverty in India through education and
scholarship grants.

The interview with Pabrai was conducted by Dr. Nupur Pavan Bang
(nupur_bang@isb.edu), senior researcher, and Dr. Vikram Kuriyan, director of
the Centre for Investment, Indian School of Business, Hyderabad.

Tell us
about your belief in the concept of compounding.

Einstein called compounding the 8th wonder of the world. Let me
tell you a story.

One day an inventor of games brought a game to the
king- the game of chess. Since it was about battle between two armies, the king
was amused and spent a lot of time playing the game. So impressed was he that
he offered the inventor to ask for any reward. The inventor asked that he be
given an amount of rice that would be equal to what the board could hold if we
were to start doubling one grain of rice from the first square of the board up
to the 64th square.

The king thought that this was a petty and stupid
request and ordered for the reward to be given. The minister who was in charge
of arranging this did not return for a few days. Upon inquiring about the delay
the minister said that the whole kingdom did not have the
18,446,744,073,709,551,615 grains of rice required, or close to $300 trillion
worth. Much greater than the combined wealth of the earth.

Such is the power of compounding. This is a concept
that many great investors have time and again used for wealth creation. The
celebrated Warren Buffett is a great example.

Warren
Buffett and Charlie Munger have had a lot of influence in your life. How did
you first learn about them and what got you interested in them?

In
1994, I was 30 years old and heard of Buffett for the first time. I did not
have any knowledge about investments or capital allocation. Around that time, a
couple of his biographies were published. I read them and looked at his track
record from 1950 to 1993. Over 44 years he had compounded money at 31% a year.
If you compound money at 26% a year, it will double every three years; at 31%
you will double in less than three years. I thought about the story of the chess
board again and realized that if Warren continued doing what he was doing, he
would become the wealthiest person on the planet. He did became the wealthiest
person on the planet.

I
have never been to a business school and thought of investment, but few things
stood out to me. In the investing world, hardly anyone followed Warren Buffett
and hardly anyone generated returns the way he did. However, I thought that his approach to compounding was
right, and these things were related. Buffett’s approach looked replicable,
but no one was doing that. I liked compounding and thought of giving it a try.

How did you start? Where did you
get your initial capital from?

I
had sold some assets in the business I was running at that time [1994] and
ended up with $1 million in the bank. I had no immediate use for that money. When
I read Buffett’s biography,I decided to
play his game for 30 years. If I compounded at 26% a year, and my money would
double every 3 years, a million would become a billion in 30 years. I thought
that even if I fail by 95%, or 97%, I would be okay.

Swami Vivekananda used to say, "Take one
idea, make that one idea your life. Think of it, dream of it, live on that
idea. Let the brain, muscles, nerves, every part of your body be full of that
idea, and just leave every other idea alone. This is the way to success".
That is exactly what I did.

Could
you tell us a little bit more about your journey from then on?

In
1995 I started putting the million dollars to work. By 1999, $1 million had
become $5.1 million, growing at 43.4% per annum, way above my target of 26%. So
I said, I think this could be done.

When did you start Pabrai Funds?

I
used to give investment tips to friends and family. They would ask me to manage
their money. So, in July 1999, I set up Pabrai Funds with $1 million in assets
from nine investors. From 1999 to 2007, we compounded at 37.2% per annum before
fees, 29.4% after fees.

Did the financial crisis hit
you?

Oh
yes, it hit everyone! From the mid 2007, for the next 21 months, we compounded
at a negative 47.1%. That came to an end in 2009. Eighteen and a half years
after I first started [1995 to mid 2013], I have compounded at 25.8% per annum.
Short by 0.2. The good news is that I still have 11.5 years left, and in
investments, the more you play, the better you get at the game (unlike tennis).
I am excited to see how next 11.5 years unfold.

So how do you compound at 26%- especially
since you were not formally educated in finance or investments? [Editor's note: Pabrai left his
master's degree program at Illinois Institute of Technology to start his
consulting and systems integration company, TransTech.]

When
I set up Pabrai funds, I looked at the Buffett Partnership. It was closed in
1969; I opened in 1999. In that 30-year period, I did not find a single fund
that replicated the Buffett model. I got all the information that I could about
the model from published sources, took it to my lawyer and told him to simply
replicate it. I adopted cloning in a very serious manner. I then started
investing in stocks in which Buffett and his Berkshire Hathaway invested.

Why is it that we don't see many
others succeed like you have? If it's only about cloning, anyone can do it.

That's
right. Anyone can do it. But nobody does. There is something strange in the
human genome which makes people think that cloning is beneath them. Everyone
wants to do something unique.

There
are other examples of cloning that have succeeded. If you look at Microsoft, Excel
was cloned from Lotus; Windows, Word, and a lot of its other products are
cloned. It's not even a great cloner, as most of its products take a number of
versions to remove bugs. Even though Microsoft is not a great cloner, it is one
the most successful companies in the world.

McDonald's
spends a lot of time to figure out locations for their franchisees. They do a
lot of analysis. While Burger Kings that compete with McDonald's, just look at
where McDonald's is opening up.

There
is a lot of debate going on about letting retailers like Wal-Mart into India.
What perplexes me is that there is nothing in Wal-Mart's business model that
anyone cannot figure out by walking into their stores. There is nothing in
their model that cannot be replicated. India does not need Wal-Marts. It just
needs an entrepreneur to look at their model and replicate it.

Do you blindly follow Warren
Buffett and invest in any company he is investing in?

There
were some professors in the U.S. who looked at every stock Warren Buffett
bought from 1975 to 2005, and they did an analysis. If you bought what Buffett
bought after it became publicly known, on the last day of the month at a higher
price and held it until Buffett started selling and sold it after it was known publicly
that Buffett had sold, and got the price which was the lowest price on the last
day of the month, and you did this for every stock he bought and sold for 30
years, you would beat the index by 11.5% a year.

Bottom
line, cloning is a very powerful notion. No good books have been written on
cloning yet. If you take what Buffett did, then you are already beating the S&P
by 11.5% per year. Mostly what Pabrai Funds did was to copy the other investors.
I just give a slight tweak to it. I don't buy what others are buying. I look at
what they are buying. Then I buy what I can understand and limit myself to two-three decisions a year.

How has your strategy evolved
over the years?

We
don’t learn from success. When we stumble we learn a lot. I am grateful that every
time I stumbled, it has lead to growth. The period 2007-'09 was wonderful from a
growth and learning perspective. Over the entire 1999-'07 period there were no
negative returns. Not only did we make 37.7% per annum on a compounded basis, but
there were no negative returns. We thought nothing went wrong, and I never saw
the housing bubble.

In
2008-'09, financial system was out of oxygen. I had companies which depended on
access to capital markets and financing. They just went into a tailspin. In one
case, our investment went to zero. We had permanent losses. We had things which
were knocked down on price and we had no ability to be offensive. We had no
cash. I learned the rule that cash is king. Most of last year I was sitting
with 20% cash. That was a big change.

Another
change in my approach was the development of a pre-investment checklist, which is
very powerful. It looks at mistakes made by other investors. This checklist
helps me in catching those mistakes. One of the Warren Buffett biographies
reveals that as a kid he used to walk in a strange way. It was to absolutely
take out the probability of falling. He picks stocks similarly. He looks at the
downside- how can he lose money. SoI
did the same...questioning and re-questioning many times about how can I lose
money on an investment. The checklist helps me there.

Also,
I started having conversations with another investment manager. I got this advice
from Charlie Munger, who said he always has someone to talk to about his
investments. Until 2008 I never talked to anyone about investments. We mostly
never agree, but conversations are helpful.

What about your fee structure?

My
investors love my fees structure- which is copied straight from Buffett. Zero
management fees for assets under management.First 6% of returns go to the investor. Above that 6%, I get one-fourth
and they get three-fourths. So if the portfolio is up 10%, I get one-fourth of 4 percent (that is, 1%).
If it is up 5%, we get nothing.

Warren Buffett is a Value
investor. Isn't it very restricting to just copy him? There may be many more
opportunities out there that may not strictly fall under the Graham and Dodd
definition of a value investment, and yet be a great opportunity.

Well,
Buffett is a multi dimensional investor. Dozens of investments that he has made
are not moat based or may not be value investments. For example he has done a
lot of restructuring and arbitrage deals. It is not so much about moat or value
investing. It is about what you pay for a business. If you pick four or five
investors and decide to pick the best of their ideas with some of your own
criteria put in, you will be fine. You can skip the businesses which you don't
understand or which are in conflict with your own criteria, and you will still have
enough options to invest. Keeping it simple and buying at a great price are
important. It is also important that if you are cloning, you clone the best.

"I am
not a superman", he says, but the reaction of markets to his initiatives
has been super indeed. He took over the office of RBI Governor amongst much
hustle and media gush on September 4, 2013. Having predicted the financial
crisis and carrying an image of an internationally recognised economist,
Raghuram Rajan was seen as the savior for the Indian economy that had multiple
economic issues to grapple with.

He had his guns ready and fired right away on the
day he took over. He endorsed transparency and financial stability in addition
to issues related to inclusive growth and development. A range of measures were
announced that included elimination of license requirements for new bank
branches, appointment of committee to assess RBI’s approach to financial
inclusion, allowing rebooking of cancelled forward exchange contracts by
exporters and importers, issue of cash settled ten year interest rate future
contracts, interest rate futures on overnight interest rates, special
concessional window for swapping FCNR (B) dollars, increase in foreign
borrowing limit of banks to 100 per cent of unimpaired Tier I capital, etc.

On Financial Infrastructure front, he expressed an
intention to implement Electronic Bill Factoring Exchanges to facilitate prompt
bill payment facility to Micro Small and Medium Enterprises (MSMEs). He
acknowledged the need to have Debt Recovery Tribunals and Asset Reconstruction
Companies for efficient loan recoveries.

For households, the governor announced that they
will issue Inflation Indexed Savings Certificates, come out with national
giro-based Bill Payment System to facilitate bill payments any time, start mini
ATMs operated by non-bank entities for better financial access.

These measures were well received by markets as the
key economic indicators improved swiftly. Depreciating rupee that had been a
cause of concern for some time, gained considerably from a low of Rs 68 per
dollar on August 29 to stabilise at Rs 62 per dollar by September 16.

Sensex rode on investor expectations of favourable
policies by the RBI and rallied by a maximum of 700 points, eventually crossing
the psychological mark of 20,000 points. Forex reserves also remained stable
during the time. Gold imports remained low at 7 tons in September helping
India's current account deficit. Only thing that remained unleashed was
inflation that rose to 6.46 per cent for the month of September 2013 (see
Figure 1).

Figure
1: Key Financial Indicators before and after Raghuram Rajan’s taking over

Source: Reserve Bank of India; www.bseindia.com;
www.oanda.com;

In order to arrest inflation, in his first monetary
policy review on September 20, Rajan increased the interest rate to 7.5 per
cent (by 25 basis points), against the common expectations. This might have
irked Finance Minister P Chidambaram, but he remained quiet, while he had
openly criticised Rajan's predecessor Subbarao for a similar move.

Rajan maintained that controlling inflation was
important which eventually provided a growth environment pretty much in line
with his predecessor’s line of thinking. He made up for the increase in
interest rate to some extent by rolling back the rate on Marginal Standing
Facility (MSF rate is the rate at which the RBI lends emergency funds to the
banks) to 9.5 per cent from 10.25 per cent earlier (it helped reduce the cost
of funds to banks and hence their lending rates).

In one of the measures, norms for Non-Resident
Indian (NRI) deposits and overseas borrowings by banks were relaxed. This
helped the foreign exchange reserves of the country. When Rajan took over, the
reserves were at three year low of $274 billion. A month after, the reserves
are up by $5.6 billion.

The month of September also saw gold imports go
down that resulted in trade deficits to trim down to a 30 month low of $6.76
billion, resulting in a much lower second quarter (July-September 2013) deficit
of $29.9 billion as against $50.3 billion in the first quarter (April-June
2013).

On October 3, Rajan met Chidambaram and decided to
provide additional capital to banks for lending to auto and consumer durables
sector. On October 7, RBI reduced the Marginal Standing Facility rate by
another 50 basis points (now 9%) to bring down the cost of funds to the banks
(RBI had increased the MSF rate from 8.25 per cent to 10.25 per cent in July
2013). Two reductions in MSF indicated that the rupee position of India was
comfortable. According to Rajan, current account deficit of $70 billion was
achievable at a stable rupee.

On October 10, RBI allowed banks to raise funds
from international institutions until 30 November 2013 for general banking
purposes (not for capital enhancement). On October 12, Rajan announced that
major reforms in the form of allowing foreign banks to enter and takeover
domestic banks were to be introduced in the coming months.

He promised near national treatment to the foreign
banks subject to couple of operational conditions. In a meeting at IMF on the
same day, he pointed that India must not be seen as a country in crisis as he
did not see India running for IMF money in next five years and even beyond.

In a speech at Harvard University, Rajan stated
that Indian economy was to pick up in fourth quarter of the financial year as
government cleared stalled resource projects worth $115 billion. Also, good
monsoon season was expected to boost agricultural production. He also pointed
that economic troubles of India had to do with unwinding of stimulus during
financial crisis and increased spending on things such as gold rather than any
structural problems.

RBI launched new Real Time Gross Settlement (RTGS)
system for large-value funds transfer for settlement of inter-bank transactions
(first implemented by RBI in 2004) on October 19. Its advanced liquidity and
queue management features were expected to make financial markets more
efficient.

On October 21, Confederation of Indian Industries
and Association of Chamber of Commerce and Industries urged Rajan to cut key
policy rates for better liquidity conditions. However, the seven month high
inflation figure of 6.46% for September does not go in their favor. Given
Rajan's reputation, we may see another hike in interest rates on October 29 and
given his ability to communicate to all stakeholders, the finance minister may
not even be in a position to criticize his policies as it may not be received
well by the markets.

In this short span of time, Raghuram Rajan has
introduced/announced many initiatives, most of them yielding positive reactions
from markets. Whether this is first aid or permanent solution, is too soon to
tell.

Thursday, October 24, 2013

In an exclusive feature on Raghuram Rajan, columnist Savita Iyer-Ahrestani writes about the challenges of running India's central bank. I have been quoted in the article published by the Global Association of Risk Professionals. Do read it by clicking on the link below:

Is diversification the best way to invest in the market today? Not really. The portfolios of major investors worldwide make the case for another, often-ignored, strategy: concentration. Business schools need to refrain from pushing the merits of diversification without highlighting the efficacy of concentration.

“Do not put all your eggs in one basket. Diversify.” In 1952, investment aspirants received this clarion call fromHarry Markowitz, a US economist and Nobel laureate.Peter Lynch, the famous US businessman and stock investor, “never saw a stock he didn’t like” and was a great proponent of portfolio diversification. While managing the Magellan fund, at the peak of his career, Mr Lynch’s portfolio had more than 1,000 stocks. To date, portfolio diversification remains the most important lesson taught to students of investment and risk management. The concept is a common thread in the investment approach of most fund managers and investors.

However, if we look at the portfolios of the rich and famous, they are, surprisingly, mostly concentrated. Several great investors, spread across geographies, have very concentrated portfolios. Warren Buffett, George Soros, Rakesh Jhunjhunwala and many others are renowned proponents of portfolio concentration. To Mr. Buffett, over-diversification presented a “low-hazard, low-return” situation and thus he dismissed it. A concentrated portfolio pivots on the absolute conviction of the investor in his or her stocks and his or her risk appetite.

A diversified portfolio, on the other hand, works well if the investor is optimistic about the stock, but wary of the associated risk. Investors like the first billion-dollar Indian investor, Mr. Jhunjhunwala, walk a fine line between the two.

John Maynard Keynes, the influential British economist, was another staunch supporter of concentration. “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes,” he once said.

Mr. Buffett, echoing Benjamin Graham, the father of “value” investing, says he does not just buy an insignificant thing that bounces by a small percentage every day on the stock market. He buys part of a real business and thinks like the owner of a business would.

Mr. Buffett says: “Wide diversification is only required when investors do not understand what they are doing.” Bruce Berkowitz, founder of Fairholme Capital and a leading “value” proponent, adds that just a handful of significant positions are enough to do unbelievably well in a lifetime.

Advocates of concentration also opine that building or creating wealth with a diversified portfolio is difficult, unless the entire market is experiencing a bull phase and all the stocks in the portfolio are performing well. Even then, you may not get the full advantage of a multi-bagger as your investment in that particular stock would be just a fraction of your entire portfolio. The anti-diversification camp proposes that to generate wealth some concentration is required, provided people know how to assess their risk appetites and simultaneously pick winning stocks.

Fund managers today are caught in a catch-22 situation. Is wealth generated first by diversification and then maintained through concentration or vice versa? Knowing that concentration has been the mantra for success for most investment gurus, is it savvy to jump on the “diversification bandwagon” by adhering to popular belief? Awareness of such dilemmas and seeking clarity on them is essential for future managers.

It is, thus, time for business schools to introduce concentration as an important strategy in wealth creation, management and enhancement. Special attention needs to be given to this in business pedagogy, as the training of financial advisers and finance students will remain incomplete if it is restricted to the hallowed realm of diversification as the only plausible investment strategy.

"May you live in
interesting times. I can hardly complain on that count. I had come into the
Reserve Bank five years ago as the 'Great Recession' was setting in, and I am
finishing now as the 'Great Exit' is taking shape, with not a week of respite
from the crisis over the five years."

- Duvvuri Subbarao on
his term as the Governor of RBI

He began his tenure on September
5th, 2008 as the 22nd Governor of the Reserve Bank of India (RBI). Within days,
the roller coaster ride began. Global financial crisis set in and the newly
appointed RBI governor, Duvvuri Subbarao, geared up for toughest of the times
RBI had seen.

India had limited exposure to
international markets in the year 2008. As a result of which impact of global
financial crisis was not as severe. However, a comfortable rupee position and
foreign exchange liquidity had to be maintained along with economic growth.

Under his leadership, RBI kept
the domestic markets, to a large extent, alienated from the international
meltdown to avoid liquidity or solvency cascades. Apart from conventional steps
for liquidity infusion such as reduction in rates, he took unconventional steps
such as rupee-dollar swap facility for Indian banks, refinancing window for Non-Banking
Financial Companies and facilitating refinancing of the credit to small
industries. Through these measures, liquidity to the tune of $75 billion or approximately
7 percent of GDP of the country was induced in the economy post November 2008.

Everyone agreed that the country
had fared relatively better during the global financial meltdown. Subbarao's
original term of three years was extended for another two years by Government
of India in September 2011. Most bankers and economists supported the move as
any change in apex bank’s policies may not have been the best for the economy
at that point of time.

The year 2012 brought more
challenges for the Governor. Increased liquidity in the economy had led to a
period of high inflation starting from 2009-10 that eventually became a hot
potato. In February 2012, RBI decided to increase the bank rate from 6% to 9.5%
for the first time in nine years (there had been no change in the bank rate
since April 2003) calling it a technical adjustment.

The bank rate was decreased to 9%
in April 2012 to support the growth push that the economy needed. But seeing
the ineffective efforts of government to rein in the deficit and high inflation,
Subbarao decided to hold the bank rate unchanged from then on despite pressure
from the Center to lower it further. He had to make a tough choice between reining
inflation and supporting growth through fiscal policies that the government had
in mind. For lack of belief in the government’s plans, Subbarao took a stand in
favor of the common man and refused to further cut the rates much to the
disappointment of Mr. Chidambaram who publically expressed his anguish over it.

Listed among ‘India’s 50 Most
Powerful People 2009’ by Bloomberg Businessweek, Subbarao stood against the wide
calls to cut interest rates by the industry and the government. He stuck to his
belief that inflation hurts the common man and hence curbing it was more
important even if it meant sacrificing part of the growth.

Subbarao made efforts to make RBI
a body that was ‘communicative, honest, open minded and accountable’ rather a black
box which was a mystery for people. He had the opinion that people should know what
RBI does. He aimed to demystify RBI and make it a role model for central banks
globally.

In this direction, RBI designed
financial literacy programs and pushed the states to introduce financial
education curriculum at school and college levels to help enable the people to
demand services from banking system.

In similar direction, he pressed
on IT enabled banking, promoting financial awareness, and starting financial
inclusion drives. In February 2013, in its new guidelines for banking licenses,
RBI mandated that the aspirants, in their business plan, include ways to
achieve financial inclusion.

He was criticized for not
maintaining high forex reserves when rupee was appreciating during 2009-10.
Also, his tenure was worded as the worst by a RBI governor by Arvind
Panagariya, Professor of Economics at Columbia University. During the last few
months of his tenure, he was blamed for falling rupee. Despite all criticisms
he stuck to his guns and defended his decisions. While the government blamed
RBI’s tight monetary policy and non-cooperative policy behavior for
deteriorating economic situation, RBI governor convincingly reallocated the
blame to loose fiscal policies of the government and policy paralysis.

A Green Horn five years back, he
retired locking horns with the bosses. On September 4th, 2013, as he handed
over charge to Raghuram Govind Rajan as the 23rd Governor of the RBI, he may
not have been the favorite of the finance minister of India, Mr. Palaniappan
Chidambaram, but had certainly raised RBI's stature as an autonomous body. He
charted an independent path from the government, refused to succumb to the
pressure from the Center.

"Getting married this year
would be very costly for me. With gold prices at all-time high, jewellery
shopping will literally wipe out all my savings. My parents will insist that I
buy at least 50g of gold jewellery for my future wife. It does not make
senseright now at such high
prices", says a friend who is planning to postpone his marriage to his
fiancé.

India's finance minister P
Chidambaram has blamed the $86bn (4.5 per cent of GDP) current account deficit
on India's "passion for gold", and has introduced various measures to
curb demand. There are several reasons why such steps are unlikely to
succeed.

At the start of 2013 import duty
on gold was increased from 4 to 6 per cent. At the same time, the duty on raw
gold was doubled to 5 per cent. In February, gold deposit rules were relaxed by
the Reserve Bank of India (RBI). In March, the RBI started monitoring gold coin
sales by banks. In May, the RBI restricted consignment-based gold imports by
banks. In June, import duty on gold was hiked to 8 per cent. In July, RBI tied
gold import quantity to total imports.

But, the demand for Gold did not
budge downwards. Having failed to curb demand, a hike in import duty was
announced in August for the third time. The import duty currently stands at 10
per cent.

The bad news for the RBI and
Chidambaram is that 2013 is scheduled to have 31 extra wedding days in India,
because according to the lunar calendar only 117 days will be lost to Chaturmas
(considered inauspicious) compared to 148 days in 2012.

If it can, the Government of
India should come out with an incentive for couples planning to get married to
not do so this year. About half of gold jewellery shopping in India happens
during weddings.

India produces a negligible 2.3
tonnes of gold a year and consumes almost 1,000 tonnes a year. No points for
guessing where the balance comes from. Increase in gold demand in any year has
to be met by importing more, and given the importance of gold in Indian
marriages, any reduction or postponement in gold demand is not a reasonable
assumption.

Apart from weddings, festivals
are the second most important occasion for the Indians to buy gold jewellery.
Just under a quarter of the demand for gold jewellery is bought during
festivals in India, according to a survey by AlphaWise and Morgan Stanley
Research in 2012, compared to 43 per cent for weddings.

Diwali, the most important
festival for Hindus is in early November and people buy gold on Dhanteras to
please Goddess Laxmi (the Goddess of wealth). Our presumption is, given the
sentiment attached to buying gold and the returns it has offered post 2008,
people will not mind buying gold even at soaring prices.

In history, wars have been fought
over the ownership of gold. Now the battles take place in the form of
derivatives, exchange traded funds, and mutual funds. Gold is still much sought
after, but more so for its financial than aesthetic value. The government of
India and RBI are fighting another war against its own people.

People are wondering why the RBI
and the government would try to curb gold imports to solve a problem that is
created due to government overspending and policy paralysis. Why would a
government which is not able to protect its citizens from inflation prevent
them from buying gold, which is considered a hedge against inflation?

Gold gives a common backdrop to
an India which is otherwise diverse in religion, faith and culture. Embedded in
the Indian psyche as symbol of prosperity and wealth, owning gold is akin to
the American dream of owning a home.

Hence, the curbs on gold may not
yield the desired result. But it will succeed in building up further anger
against the ruling government.